How to Invest in Index Funds

last updated 2017-06-14

An index fund investing how to: what they are, why they make sense, and where to buy them at the best prices.

Most passive investors want to find
a balance between reliability, safety, and ease. Instead of spending their days
trading stocks looking for 1% here or there, they sleep easier at night earning
a decent average rate of return of 8% every year (over a period of decades).

No investment can guarantee that in any given year, but the
historical trend suggests that a very simple investment can do that well, if
you invest consistently and carefully. That investment is the broad US stock
market. Of the myriad ways to approach this problem, John Bogle's The Little Book of Common Sense Investing suggests that
index fund investing is the best starting point for novices and passive
investors.

Index Funds versus Mutual Funds

An index fund is like a mutual fund. A mutual fund is an investment vehicle
where multiple investors pool their money and a money manager uses the sum
total to buy and sell individual securities. Of course, you'll pay a fee for
that fund. An index fund is an investment vehicle where multiple investors pool
their money and the individual investments track a single stock market index.
This distinction is subtle; rather than relying on the expertise or whims of a
money manager, all trades follow the underlying securities which make up the
index. Perhaps that's the 30 stocks in the Dow Jones Industrial Average.
Perhaps that's the S&P 500 Index. It
could be many things.

You'll pay a fee for an index fund as well, but the fee is much, much lower
than for a mutual fund because the overhead of managing the fund is much, much
lower. This improves your return (by lowering your costs)
and reduces your risk and churn.

Index Funds versus Individual Stocks

You can buy index funds the same way you would individual stocks; often
that's as easy as searching through the options for your online broker. (You
can buy all sorts of interesting things online; all sorts of exchange-traded funds.)

While an index fund rarely offers the exciting growth opportunity of stocks, it
can often reduce risk because the index represents multiple stocks. In the case
of a broad market index such as the S&P 500 or the Russell 2000, the index
may represent multiple economic sectors. (Alternately, an index representing
the Dow may overrepresent large blue chip stocks just as a NASDAQ index may
overrepresent tech stocks.)

None of this is inherently bad; it's just information you should keep in
mind.

Should you buy individual stocks or index funds? That depends on
what type of investor you are.

How to Invest in Index Funds

John Bogle's work as the founder of the Vanguard investment company led
him to create the first index fund. Even still today, the Vanguard 500 index
fund is a gold standard against which other investments are managed. You can
invest in that index fund (or multiple other fund options) by opening an
account with Vanguard directly—no broker needed. This is a great option
if you're starting with a small amount, say $100 or $1000. You can open a fund
with a minimal investment.

If you already have a discount
broker, you will have a wide range of indexes from which to choose. You can
just as easily pick one of Vanguard's offerings there as with Vanguard itself,
or from countless other funds. In this case, make sure to understand what the
underlying index tracks and look for the lowest investment fees when you have
the option of multiple funds which track the same index. Remember, the most
important of Bogle's insights into index fund investing is to keep fees and
costs as low as possible.

Investing in Index Funds: 401(k) Version

There's one twist, if you have a company-sponsored 401(k): you may have
limited funds from which to choose, and those choices rarely include John Bogle
index fund opportunities. It's a sad fact of these programs, especially given
that the costs on these funds are higher than you could get as a self-directed investor. In this
case, you must choose carefully to minimize fees (within the possibilities you
have). You can often find an analogue to the S&P 500 index fund, and it's
often the best choice. Sometimes you may need to talk to your fund
administrator to see if you can get other options.

It won't always work, but sometimes being assertive in a couple of
conversations can save you thousands and thousands of dollars over the lifetime
of your investments.